How do you measure a business’s ability to scale while creating value?
As Venture Capitalists, we spend much of our time looking for the businesses that have the greatest ability to create value based off of the capital we invest. But the industry standard metrics measure only one aspect of the complex reality and fail to capture the full picture of the business’s performance. This leads to a complex juggling act of how the plethora of different metrics fit together and push and pull on one another.
That’s why we’ve gone back to the drawing board and developed a framework to measure the core of the businesses we look at — spending on (investing in) sales and marketing today to drive value further down the road — which is a simple conversion determined by the ratio of dollars invested to value created. We call this ratio the “Core Ratio” and like to think of the business like an engine that converts fuel (capital, today) to miles (value, tomorrow) at a rate determined by the miles per gallon (Core Ratio). All other efforts (team, product, …) should be an effort to increase the efficiency of this engine because that is what determines the value of the entire business.
Take a business with 50% margins that spent $100 to acquire customers in January. If that same group of customers (the January cohort) spent a cumulative total of $300 through the following December, the Core Ratio after 12 months would be 1.5, calculated as 0.5*300/100.
The Core Ratio provides a high level view on a company’s ability to create value. By looking at the Core Ratio and its three drivers — revenue retention, contribution margin and revenue acquisition cost — decision makers can measure performance and drive strategic decisions around product, growth and the business model itself.
The Core Ratio has a massive impact on a business’s capital needs. Between two companies with identical opex, revenue and growth, the company with a 2x better Core Ratio will burn less than half the cash in a given period and hit break-even much earlier, leading to much lower dilution for common shareholders and early investors.
Together with our sister fund, e.ventures, we’ve created software that helps us run this analysis programmatically based off of simple inputs. Here’s an example with demo data. We’ve found this tool (we call it the Data Interface) to be helpful both for us to determine the fuel efficiency of companies we’re looking to invest in, as well as our existing portfolio companies. We’re currently in the process of opening this tool up to let entrepreneurs outside our network quickly run the analysis on their business. Send an email to jonas[at]eventures.vc for a chance to be among the first companies to test the Data Interface in the coming months.
Written by: Thomas Gieselmann and Jonas Nelle